Introduction
In my first three blog posts on New Keynesian economics, I’ve ignored Foreign trade from all of our examples by assuming a closed economy (one that doesn’t trade with the outside world). This simplified previous explanations (without distorting the key points), but now it’s time to consider Foreign Trade.
I’ll explain this from the point of view of working out what factors determine what a countries trade balance will be. The trade balance is also called Net Exports (exports – imports) and tells us whether a country exported more goods than it imported (positive balance) or imported more than it exported (negative balance). But why are we so interested in Net Exports? Well countries that run large positive Net Export balances are more likely to be able to make sure everyone in their society is fully employed – which they can do by exporting excess goods produced abroad.
Table of Contents
Key Assumptions
Below are the key assumptions I’ll be making:
- There are different models in New Keynesian Long-run economics for different types of economy. I’m going to describe the simplest type that includes foreign trade, a small open economy with perfect capital mobility. What this means:
- ‘Small open economy’ – a country’s economy is small enough that its actions can be assumed to have no impact on the world interest rate.
- ‘Perfect capital mobility’ – people living in this country can just as easily invest their money abroad, and likewise foreigners can easily invest in their economy (with no extra fees or costs)
Why do these assumptions matter? A theme throughout New Keynesian economics is that the interest rate adjusts to make markets come into equilibrium. But if a country is completely open to the outside world and capital can flow in and out of it with no restrictions, then it is the world interest rate that will decide the equilibrium point, not the domestic interest rate.
Steps to Understanding Net Exports
To help simplify the below explanation I have broken it down into steps, starting with the most basic assumptions and building step by step on them.
Step One – What Determines the Economies Output
The answer in the long-run according to New Keynesian Economics is the factors of production. The economy has a certain number of factories and skilled workers and they are assumed (somewhat magically) to always be working at full capacity.
Step Two – What Determines How Much of a Country’s Produce Gets Sold Abroad?
Two factors matter here.
- The first is the ‘real exchange rate’. This reflects the fact that countries have comparative advantage in manufacturing certain things compared to other countries. For instance, Japan is particularly good at manufacturing cars because it has a highly developed automotive industry. It is much cheaper for Japan to make a car than it is for say the Republic of Ireland. No matter what the nominal exchange rate (how many Yen a Euro can buy), it is very likely that it will be cheaper for Irish People to buy Japanese cars – not the other way around
- The second is the ‘nominal exchange rate’. This is how many Yen a Euro can buy, and is the exchange rate most people are used to thinking about. New Keynesian Economists believe that the nominal exchange rate is determined by the supply and demand for a countries currency. For example, if people start buying more cars from Japan than they used to do, then the demand for Yen rises and so the price of Yen gets bid up. This is commonly described as the currency strengthening. So, if one Euro used to buy one hundred Yen, then if the Yen strengthened One Euro may only buy you ninety Yen.
If a country’s currency strengthens then the exports they sell will become more expensive for foreigners and so less exports will be sold. Likewise, local people will find that imports have become cheaper and more affordable and so buy more. Thus, a stronger currency reduces Net Exports and a weaker currency increases Net Exports. It is this mechanism that we describe next.
Step 3 – What Determines the Foreign Exchange rate?
The foreign exchange rate is determined by the supply and demand for a currency. According to New Keynesian economics:
- The supply of a currency is determined by the total savings of the general public and the government less any money that has already been invested. The idea is that people save their money in banks, and the banks then lend this to businesses to Invest. If the banks don’t Invest all of it then the remainder is left for foreigners to buy via the currency exchange. This is more formally described as:
S (Savings) – I (Investment) = NX (Net Exports)
This is derived from the National Income Identity and it’s derivation is shown next.
Derivation of Savings – Investment = Net Exports
Let’s go back to basics with the National Income Identity. Remember this just shows that total spending in an economy must equal its total income (because when I buy a sandwich the seller makes income). We focus on the spending side and its four main categories:
Y (Income) = C (consumption) + I (Investment) + G (Government Spending) + NX (Net Exports, Exports – Imports)
Recall that New Keynesian Economists believe that in the long-run total income is determined by the factors of production (number of factories and skilled workers in the economy), and that this will always be at full capacity. Therefor the value of Y is fixed (determined elsewhere). We denote Y as fixed by writing it as \bar{Y}. Consumption is a function of income, which means we will also know how much people spend on consumption as we know their income. Finally, Government spending is assumed to be exogenous (i.e. an external variable that we must just take as given).
Re-writing the National Income Identity
This can be rewritten as:
(\bar{Y} – \bar{C}– \bar{G}) – I = NX
As (Y – C – G) is Income less money spent on consumption less Government spending, this term can be re-described as Savings. Therefor:
(Savings) – I (Investment) = NX (Net Exports)
Criticisms of This Proof
It is important to note that the economy is almost never at full capacity. If an economy isn’t at full capacity then it can increase Net Exports without the requirement for savings to increase or Investment to decrease. This means that the statement ‘S-I = NX’ generally does not hold true in the real world.
Step Four – Putting it All Together
Because we know exactly how much the economy will produce (see step one), we also know exactly what total savings will be. We say that the amount of savings is fixed.
Investment is determined by the world interest rate (because we are considering a small open economy). As we know how much saving and investment there is, we therefor know how much residual money will be left over to allow foreign trade to occur.
Finally, we know certain countries are better at producing certain goods (see Step Two – the real exchange rate), and so there will always be a demand for these goods from foreign countries (Irish people want Japanese cars). The nominal exchange rate will adjust to balance the demand for these goods against the supply of the export countries currency which is available (which is ‘savings – Investment’).
Criticisms of New Keynesian theory for determining the exchange rate
The demand for a currency is determined solely by foreigners looking to purchase exports in the New Keynesian long-run theory. This assumption is appealing but again very misleading. In many developed countries the majority of the demand for currency is from financial assets, not exported goods.
Conclusion
I’ve presented a very basic New Keynesian Interpretation of how foreign trade works. The broad mechanism of the nominal exchange rate being determined by currency markets is correct, however there are two key assumptions at the heart of the New Keynesian long-run view of international trade that are wrong:
- The economy is rarely at full capacity, therefor the equation S – I = NX does not hold true in the real world
- The demand for a nation’s currency is not just driven by foreigners buying exports. For most wealthy developed countries there are other flows relating to financial assets that are far larger and more significant. Therefor the models built by New Keynesians to predict exchange rate movements are highly flawed